Weird Markets

Animal, Mineral or Vegetable?

Most of economics, and lots of life, revolves around a single concept: that of the "market". Yet despite the untold reams of papers, books and data generated in the name of the subject there’s a hole at the centre. This can be summarised simply: what, exactly, is a market?

This is akin to biologists suddenly recognising that they don’t actually know what an animal is despite the fact that they’ve been studying the behaviour of the things for centuries. If the existence of markets is the core assumption upon which economics exists what happens if either it turns out they’re a figment of the imagination or even simply just one way of many of understanding the world of human financial interactions?

Read Full Post >>

Your Financial Horoscope

Using the latest in IP address geo-detection and profiling technology we’re delighted to bring you your personalized horoscope:

You have a great need for other people to like and admire you. You have a tendency to be critical of yourself. You have a great deal of unused capacity which you have not turned to your advantage. While you have some personality weaknesses you are generally able to compensate for them. Your sexual adjustment has presented problems for you. Disciplined and self-controlled on the outside, you tend to be worrisome and insecure on the inside. At times you have serious doubts as to whether you have made the right decision or done the right thing. You prefer a certain amount of change and variety and become dissatisfied when hemmed in by restrictions and limitations. You pride yourself as an independent thinker and do not accept others’ statements without satisfactory proof. You have found it unwise to be too frank in revealing yourself to others. At times you are extroverted, affable, sociable, while at other times you are introverted, wary, and reserved. Some of your aspirations tend to be pretty unrealistic. Security is one of your major goals in life.

Trick or treat?

Cargo Cults

In the Second World War many remote Pacific islands found themselves occupied by warring forces. This often led to an unexpected windfall for the primitive islanders as the troops were supplied from the air with unimaginable luxuries like corned beef, custard powder and anti-aircraft guns. When the war ended and the troops went home the planes stopped coming so, naturally, the islanders hatched a cunning plan to make them come back again.

They created the rudiments of the apparatus that the ground crew had used – paddles to welcome the aircraft, fake headsets for the radio operator, fake landing lights – and engaged in the same strange ritual ceremonies, behaviour generally known as a cargo cult. Yet no matter how they adjusted the ceremony they couldn’t get it quite right and the planes never came back. It would be crass simplicity to suggest that the same kind of magical thinking pervades the world of investment. Only it does, of course.

Paranormal Beliefs

The curiously enduring nature of belief in the paranormal is one of the mysteries of the modern age. Less than 50% of the world’s population believes in evolution despite copious evidence in its favour, much of it propping up the nearest bar, yet a majority happily accept the probable existence of invisible, incorporeal and undetectable entities of which science can find not the slightest trace. This isn’t explicable under the normal definition of “rational”.

Many practitioners of magic argue that this widespread belief in things that go bump in the night is de-facto evidence that there must be something “out there”. Only almost certainly there isn’t, but there’s definitely something going on inside our heads: we’re infinitely suggestable. This factor, combined with our desire to seek forms of control in situations of extreme uncertainty is a powerful driver of behaviours that we’re apt to label as “irrational” when, in fact, they’re nothing of the sort.

When the Irrational Isn’t

The smoking gun that leads to the redefinition of “rational thinking” was discovered in the Trobriand Islands. The anthropologist Bronislaw Malinowski noticed that the islanders engaged in elaborate rituals when they went deep sea fishing but not when they were fishing inshore. He surmised that the open seas superstitions were an attempt to protect themselves from danger in a fundamentally uncertain environment.

This tendency to attempt to exert some form of control, no matter how illusory, in the face of great uncertainty, seems to be part of the human condition. Various studies, including this one on the superstitious behaviour of baseball players, back the theory up. The evidence is that people attempt, always, to put themselves in a position where they feel they have control of the situation, regardless of the reality: the so-called “illusion of control”.

Magical Investment Thinking

Now, boys and girls, can we think of another situation where people are essentially at the mercy of random and unpredictable events and spend a lot of time developing ritual behaviours to make them feel as though they have control of the unfolding events? Admittedly, the stockmarket is an extreme example of the genre – a global manifestation of a belief in magical forces leading to the mass delusion that we can predict the movements of individual stocks, markets and economies.

While primitive tribesmen have mystical seers, priests and soothsayers we have investment analysts; while they have chicken entrails, hallucinogenic drugs and animal sacrifice we have multi-year earnings forecasts, better hallucinogenic drugs and occasional executive bloodlettings. Simply clothing the magical rituals in a smart suit and a well formatted report doesn’t make the outcome any more predictable and the rituals any less pointless, but it does make us feel better when things go pear shaped and we go looking for reassurance.

Logical or Astrological?

In fact if this theory is correct we should see an increase in such magical behaviour during conditions of extreme market movements; a greater reliance on divining the future using essentially random techniques, and indeed we do. In times of uncertainty many people abandon any pretence of higher cognitive functioning and head off in search of their nearest soothsayer.

For instance, if you type “investment astrology” into Google you’ll get over 2 million hits. The survival of astrology into the modern age is itself remarkable but huge swathes of the world’s population still conduct their lives according to the prophetic divinings of invisible, undetectable and unmeasurable forces that enmesh us at birth and mark us for life. Apparently.

Yet, as has been repeatedly demonstrated, the evidence for astrology actually working is decidedly thin away from areas of human suggestability. So, for instance, those people who believe in astrology tend to have personalities that conform to their astrological signs while people who don’t, don’t. Belief is a powerful weapon in human systems but it sadly doesn’t mean that magical thinking can actually have an effect on the physical world around us.

Supernatural Stockmarkets

Only, of course, the stockmarket isn’t the real world. It’s an artefact of human construction and is therefore open to manipulation through all of the kinds of things that we let affect us. In theory the performance of stocks on the market is determined by fundamental factors like earnings, competitive advantage and marketing. In the long-run this is generally true, but in the short-term magical modes of thinking can easily overwhelm more fundamental factors.

Still, you’d assume that if astrology, charting and other magical modes of prediction were completely useless then their repeated failure would eventually persuade people to give them up in favour of something more rational like chain-saw juggling or duck weaving. However, it’s far from being that simple because we’re all subject to being fooled by a behavioural trick called the Barnum Effect.

Roll Up, Roll Up, Get Things Wrong

This was first demonstrated in 1949 by Bertram Forer who constructed the fake horoscope at the head of this article using the most general astrological statements he could find. He presented this to his students, explaining that it had been customised for each of them when, in fact, he gave everyone the same reading. When he asked them if it accurately represented them they virtually all agreed that it did. This trait – to see insightful information in the most general rubbish – is the stock in trade of all magicians, astrologers and other sayers of soothes:

“It was pointed out to them that the experiment had been performed as an object lesson to demonstrate the tendency to be overly impressed by vague statements and to endow the diagnostician with an unwarrantedly high degree of insight. Similarities between the demonstration and the activities of charlatans were pointed out”.

Everyone is prone to the Barnum Effect and it works because we think the same way. We read into things whatever we want to: again, it’s not that there’s anything “out there”, it’s all inside our heads.

Stocks that go Bump in the Night

The idea that most investment is driven by magical thinking underpinned by psychological tricks like the Barnum Effect is disquieting, but once you start looking for examples it becomes all too easy to find them. Astrology is simply the most obvious outward sign of this, but sneering at astrological investment techniques while continuing to faithfully follow more orthodox but equally magical processes ignores that this is the way most of us deal with uncertainty.

For children Halloween comes once a year but many investors spend their entire lives trick or treating. Sadly most treats are just tricks and most tricks are just illusions that we fool ourselves into believing. Trouble is we can only see this with hindsight – and that’s if we ever figure it out at all.


Related articles: Science, Stocks and Superstition, O Investor, Why Art Thou Rational?, Don’t Lose Money In The Stupid Corner

The Business of Capital is Bust

Investment Bankers Aren’t Hairdressers

In a recent Financial Times article one of their feature writers opined that the main problem the world has with investment banker bonuses is jealousy rather than the unfortunate fact we’re going have to sell our children to pay off the debt their antics have mired us in. She goes on to expound on how these monetary geniuses offer unique services that deservedly command huge fees by way of an extended metaphor about hairdressers who are able to charge £300 for a haircut that doesn’t require blow-drying for a quarter. I have a local barber that does the same for £295 less. It’s called a crew cut.

The discourse of jealousy is rife in financial circles at the moment, it being an easy way for poor put-upon bankers to justify and defend themselves to themselves. The reality’s more complex and deserves a properly serious treatment because investment banking is a vital function in the modern world. The business of capital needs a proper defence, not half-baked childish psychological theories which merely justify the status-quo and irritate the hoi-polloi without addressing the real, underlying problems.

Good Capital, Bad Capital

If we needed evidence of how important the business of capital is to our economies then the problems of the past couple of years, when the availability of investment capital has suddenly been choked off, should be sufficient. Without massive, free flows of capital our world doesn’t function very well and those people who are able to create, manage and direct those flows are incredibly important. Whether we like it or not such people will make vast amounts of money as they levy their tolls on the passing financial traffic.

However, there’s good capital and there’s bad capital and it’s fiendishly difficult to tell the difference (although when it’s directly borrowed from taxpayers at century low interest rates it’s a bit easier to spot). Unfortunately the downside of the creation of bad capital takes time to become clear and if we reward the purveyors of it in the same way as we reward the managers of the good stuff we create perverse incentives for quick-rich merchants to dig a huge financial black hole for taxpayers to backfill – see Perverse Incentives Are Daylight Robbery and Gaming The System for a more extended discussion of this.

It’s inevitable that those people able to generate huge amounts of capital will come in for a certain amount of opprobrium since they’re the embodiment of the destructive processes of capitalism. They oft-times make huge fortunes by destroying the livelihoods of others but, in so doing, open up new investment and business opportunities that would otherwise have languished in abeyance due to the lack of investment capital. That’s capitalism for you – the guys in the black hats win every time but the Lone Ranger gets to trade in Silver for a T-Bird and a winter condo in Florida.

Michael Milkin, Capitalist Hero

Take Michael Milkin, the junk bond trader who eventually spent time in a US penitentiary for securities violations. Milkin is popularly regarded as the embodiment of greed and as an essentially destructive force. His ability to raise huge quantities of capital was a major factor behind the rise of the leveraged buyout (LBO) which saw many well known businesses getting taken over by sharp pencilled financial specialists whose main aim was to generate excess returns on previously moribund capital by gearing up balance sheets to generate yet more capital for further corporate actions.

Ultimately this process extended into so-called ‘greenmail’ where potential takeover victims found themselves on the end of phantom takeovers where the aggressor was able to use Milkin’s promise to raise capital to fund the takeover as leverage to force capital reconstruction. In common parlance this meant that the target companies had to take on debt to return capital to shareholders – including the greenmailers.

Efficiency at the Point of a Knife

While all of this is vaguely unsavoury and clearly impacted ordinary workers in the target companies, many of whom lost their jobs as a result of the efficiency improvements needed to fund the corporate activities, there is an economically important benefit to such actions. Done properly these types of activities release capital tied up in old, inefficient and slow growth businesses to invest in new, efficient and high growth ones. Arguably without Milkin there’d be no internet. Unfortunately, once a financial bandwagon starts rolling it’s hard to avoid every greedy copycat in the vicinity jumping on board.

So it was with LBO’s as the levels of leverage being applied to takeover victims grew steadily higher and higher. With such mounting debt came ever more dubious justifications from the investment industry, ending with the analogy that excessive debt made managers more careful, like a driver with a dagger mounted on the steering wheel, pointing at their heart. As Warren Buffett wryly observed, that just means that the smallest pothole is fatal. So it proved of the most highly geared companies. And Michael Milkin, hero of the capitalist system, went to jail.

Excessive Gearing

It’s in the nature of the business of capital to overreact in this manner and the system of incentives that lies behind it is a major factor in these swings. By rewarding the creators of bad capital just as heavily as the creators of good there’s every reason for every individual to chase the capital dog to the very limit – which usually means the creation of excess gearing.

The breakdown in world finances that the world has suffered since 2007 is largely due to the investment banking industry finding ever more creative ways of generating capital. We saw in It’s Not Different This Time that the excess returns made by banks since the early 1990’s are almost entirely attributable to increases in leverage of their balance sheets rather than a reward for skillful and intelligent risk taking. Which is what you get when you reward people for generating capital without regard for its pedigree.

An Anthropologist on Wall Street

Part of the problem for the financial industry is that it deliberately sets out to generate insecurity, because in movement and instability lies opportunity. If there’s no corporate activity then there’s no money being generated. This insecurity drives to the very heart of the investment business as the individuals within it seek to maximise their returns in the minimum time available, before they themselves are reorganised.

As Karen Ho, in her anthropological study of Wall Street, has observed, this restlessness translates into the need to create corporate instability outside of the financial industry and has major implications for workers in industries with no experience or capability of dealing with the levels of insecurity this causes. The ordinary employee simply doesn’t have the skills to cope with the type of seismic change that investment bankers habitually live with.

Greedy and Responsible?

It’s little wonder that when the folks on Main Street think of investment bankers it’s not as the lubrication that makes the free, capitalist world go round but as a bunch of overpaid, greedy and remote technocrats with little understanding of the real world. Which is probably not too far from the truth, even if it’s a bit one-sided.

However, the business of capital is far too important to the world to leave it at that. The investment banking industry needs to reform itself from within: there are no people better situated to flag the difference between good capital and bad and to create incentivisation schemes that differentially reward the purveyors of each. A socially responsible capital creation industry is probably a bit too much to hope for, but a system of delayed incentives based on the generation of real returns as opposed to simply rewarding the creation and movement of capital will go a long way towards creating an industry and a global economy subject to less inherent instability.

Reform or Be Reformed

It’s already clear governments are going to enforce changes which, mostly, will end up damaging the capital generation capabilities of the world. This is because, external to the industry, no one can differentiate between bonuses for good capital and those for bad – so you get a “one size fits all” solution which suits no one and will lead to subdued global growth for years to come. The natural inclination of the denizens of the world of capital creation is to grab as much as they can now, ignoring the fact that this money has been spirited away from consumptive children, poorly puppies and impoverished pensioners to prevent an even greater crisis.

For the sake of the industry, and the world, it would be better if the investment banks addressed their own problems rather than simply moaning about the irrelevant jealousy of the masses because, unless they do, the business of capital will be bust for a generation. The world can do without £300 hairdos but it can’t survive without good investment banking: it’s time to take a razor to both.


Related Articles: Moral Corporations: An Oxymoron?, Hedge Funds Ate My Shorts, Gaming The System, Perverse Incentives Are Daylight Robbery, It’s Not Different This Time